From developing your big idea and naming your brand to building a killer website and finding those first customers, starting a business is a thrilling journey. But something else also goes into the equation: establishing the proper foundation and structure for your business.
Incorporation may not be the sexiest part of entrepreneurship, but it’s a necessary step in setting up a legal entity recognizable by your state and the federal government. Think of it as the unglamorous but necessary grunt work of launching a successful new business venture.
In this post, you’ll learn about the different types of businesses and how to choose the best one for success.
Why your business structure matters
Your business’s legal structure has a significant impact on its taxation, liabilities, and access to funding and capital. Different structures apply depending on whether you are forming a business partnership, corporation, or limited liability company. Despite these variations, incorporating your business can provide numerous advantages, such as:
- Better chance to secure business funding
- Transferable business ownership
- Security of personal assets
- Limited liability in the case of legal issues related to the firm
- Potential for tax savings
- Distinct credit rating regardless of your personal credit score
- Earlier retirement
Each business structure comes with its unique ownership, legal, funding, liability, and tax considerations.
Types of business structures
Although each business structure offers benefits, certain types of businesses are more suitable for new entrepreneurs. Note that it’s possible to change the legal structure as your business evolves over time, though this adds to the administrative steps.
1. Sole proprietorship
A sole proprietorship is a basic business structure in which there’s no legal distinction between the company and the person who owns and runs it. It’s a straightforward option that’s easy to establish and maintain.
Some ecommerce startups with low liability risk and startup costs choose sole proprietorships. While a sole proprietorship can transform into other business structures later, it’s the quickest and simplest starting point.
2. Limited liability company (LLC)
Limited liability companies (LLCs) are the perfect mix of partnership ease and corporate liability protection. They provide a middle ground between the two and technically are a type of corporation, with limited liability partnerships falling under the same umbrella.
Owners of an LLC, known as members, directly pay taxes on the LLC’s profits. This means the business structure doesn’t file taxes as a separate legal entity. Additionally, LLCs with more than one member can choose to be taxed like partnerships or corporations, which eliminates the separation of personal and business taxes.
Since their creation, LLCs have been steadily gaining popularity. According to IRS data, while other corporate structures have declined since the 1980s, LLCs have experienced significant growth.
The duration of LLCs varies depending on the state, with some dissolving when a member leaves. Overall, they are an excellent business structure option for solo founders just starting out.
3. General partnership (GP)
General partnerships involve two or more people running a business together. They work similarly to sole proprietorships for tax purposes. For example, profits are only taxed once, at the partners’ personal income levels.
In a general partnership, everyone gets to participate equally in making decisions. However, all partners also face the same risks. If the business accumulates debt or gets sued, each partner’s personal assets can be at stake.
There’s no legal separation between the partners and the business itself. This means that each partner is responsible for the actions of the others, making it important to choose your co-founders carefully.
4. Limited partnership (LP)
Limited partnerships work a bit differently than general partnerships. You still have two or more owners and benefit from pass-through taxation. But, in a limited partnership, the partners aren’t personally liable beyond what they’ve invested.
A downside to this structure is that limited partners don’t get much say in daily operations. Decisions are mostly made by general partners, which can be frustrating if you want more control or have ideas for improving the business.
Note: Every limited partnership must include at least one general partner who assumes unlimited liability for the business.
5. Limited liability partnership (LLP)
A limited liability partnership (LLP) involves two or more partners and benefits from pass-through taxation. Each partner in an LLP is responsible only for their own actions and not for the business’s debts or the actions of other partners.
LLPs offer clear separation between personal assets and business liabilities, which can be a major advantage. However, this structure is typically available only to specific licensed professions, like accounting or law.
6. C corporation
C corporations, often referred to as C corps, are among the most common corporate structures, especially for larger companies. This structure treats the company as a separate legal entity, which means it offers strong personal liability protection for its owners.
A significant benefit of a C corp is the ability to raise capital by issuing stock. You can create multiple classes of shares, such as common and preferred stock, which makes it easier to attract investors.
However, forming a C corporation involves a complex setup. You’ll need to go through a detailed filing process, create bylaws, and appoint a board of directors, which can be time-consuming and require significant oversight.
The biggest drawback is the double taxation issue. C corporations pay taxes at the corporate level, and then shareholders are taxed again on dividends. This can be a disadvantage compared to other business structures that enjoy pass-through taxation.
Note: With Shopify Plus, C corporations can customize their ecommerce solutions to meet their unique business needs.
7. S corporation
S corporations, or S corps, are formed to avoid double taxation. While C corporations pay income tax both on corporate earnings and again on shareholders’ dividends, S corporations sidestep this by being pass-through entities. Instead of corporate taxes, income is only taxed once at the personal level of owners and shareholders.
This tax benefit comes with limitations, though. S corps can issue stock to only up to 100 shareholders, and they must be US citizens or permanent residents. This makes fundraising and broad investment more challenging compared to C corporations.
8. Benefit corporation
A benefit corporation, often called a B corp, is a for-profit business recognized by many US states. Although they’re taxed like C corps, they focus on positively impacting local communities and the environment.
While they aim to do good and make profits, they must also meet the same standards as C corporations. In addition, a B corp needs to publish an annual report that evaluates its social and environmental contributions.
9. Joint venture
A joint venture involves a partnership between two or more independent businesses. In this setup, companies collaborate by combining resources for a specific task, usually for a limited time.
Examples include joining forces to win a contract, buy property, or adapt to new industry rules. The benefit here is that companies can leverage each other’s resources while staying separate entities.
The downside? Each participant bears the responsibility for any costs and losses arising from the joint venture.
10. Nonprofit
A nonprofit is a business recognized by the IRS as tax-exempt because it promotes a public good. It’s mainly about a business’s tax status, since most nonprofits are also corporations.
Forming a nonprofit offers a significant tax benefit. If your business qualifies as a 501(c)(3), it doesn’t pay federal income tax.
However, nonprofits have restrictions on their business activities. They must reinvest any profits back into their mission.
How to choose the right business structure
Selecting a business structure isn’t straightforward. Many online retailers start as sole proprietorships or partnerships before incorporating, but unlimited personal liability can be concerning. Ultimately, the business entity you choose depends on various factors. It’s essential to consult an attorney to determine the best structure for your business.
Typical considerations include:
Personal liability
Business incorporation creates a separate entity from you, reducing personal risk for some businesses. Some structures offer stronger protection, such as a corporation, while others, like partnerships, offer less. Analyze your personal situation to determine the appropriate level of personal liability for your individual self.
Bringing on partners
If you plan to have a partner in your business, you’ll need to choose a business structure that can support a business partnership. Some options to consider include a general partnership, an LLC with multiple members, or a corporation.
Hiring employees
The legal structure of your business plays a vital role in staffing decisions. Sole proprietors can’t hire employees, so if you plan to onboard staff, you’ll need to change your structure. Starting as a sole proprietor may give you more autonomy and flexibility, but it’s crucial to consider your future staffing needs.
Business funding
Incorporating can help you build credit and a financial history for your business, making it more eligible for financing from potential lenders or investors. Consider Shopify Capital for funding to help you take your business to the next level.
Business entities and tax exempt status
The US Internal Revenue Service (IRS) and other tax authorities apply different tax treatments to businesses based on their type. Each business type has its specific tax implications.
Business tax statuses include:
- Pass-through tax status: Taxes on earnings pass directly to the owners or shareholders, who pay personal income tax on their share, skipping corporate income tax.
- Nonprofit tax status: Qualifying nonprofits receive tax exempt status at federal and state levels, which means they do not pay corporate income tax.
- Corporation tax status: Corporations face corporate income tax on their profits and shareholders pay again on dividends received.
Ready to take the next step?
Incorporating your business has numerous advantages, from protecting your personal assets to building credit and history for your company. In some instances, it may even minimize your income tax. However, the most significant benefits of business incorporation are less tangible.
By officially incorporating your business, you’re taking the first step toward transforming your idea into a successful and legitimate enterprise, but the success that follows will depend on your continued efforts.
Types of businesses FAQ
What are 4 types of business structures?
When incorporating a business, you can choose from the following four structures:
- Sole proprietorship
- Partnership
- Corporation
- Limited liability company (LLC)
Which types of businesses are best for taxes?
Each business type has distinct advantages and disadvantages concerning taxes. Sole proprietorships, for instance, are subject to self-employment taxes, but can reduce their tax load through itemized deductions. In contrast, corporations are not subject to self-employment taxes. It’s essential to consider the tax implications of each business structure carefully and evaluate which option will work best for your particular circumstances.
Is it better to have a corporation or LLC?
While both corporations and LLCs offer limited liability to businesses, an LLC is more suitable for owner-operated SMBs looking for less red tape and greater flexibility. A company looking to raise funds and scale, on the other hand, should structure itself as a corporation.